For tax years beginning in 2014, the new IRS regulations on tangible property are effective. The tangible property regulations govern the tax treatment of amounts paid to acquire, produce, or improve tangible property. The regulations explain when those payments can be deducted, which confers an immediate tax benefit, and when they must be capitalized.
The regulations are lengthy and complex. The summary below addresses how the regulations treat issues of deduction and capitalization and provides guidance on implementation. Please contact us to discuss any questions regarding the application of the new regulations to your specific business situation.
Capitalization or deduction. The regulations set forth the general rule that amounts paid to improve a unit of property must be capitalized. An improvement is defined as an expenditure that betters a unit of property, restores it, or adapts it to a new and different use.
On the other hand, the regulations allow a current deduction for repairs and maintenance to property. Deductible repair and maintenance expenses are defined in a negative way-they are deductible if not otherwise required to be capitalized.
Unit of property. One key concept in the regulations is the identification of the “unit of property” (UOP) that is being improved or repaired. The smaller the UOP, the more likely it is that costs incurred in connection with it will have to be capitalized.
Property other than buildings. In general, for property other than buildings, a single UOP consists of all components that are functionally interdependent, such that one component can’t be placed in service without the other components.
Buildings. When it comes to buildings, the regulations generally treat each building and its structural components as one UOP-the “building.” The regulations also list nine specific building systems that are treated as separate from the building structure: heating, ventilation, and air conditioning system; plumbing system; electrical system; escalators; elevators; fire-protection and alarm system; security system; gas distribution system; and other structural components identified by the IRS as a building system. An improvement to the building is defined by its effect on those systems, rather than on the building as a whole.
Deducting materials and supplies. A deduction is allowed for amounts paid to produce and acquire materials and supplies that are consumed during the year. Materials and supplies are defined to include tangible property that is used or consumed in the taxpayer’s business operations that is not inventory and that:
Is a component acquired to maintain, repair, or improve a UOP owned, leased, or serviced by the taxpayer and that is not acquired as part of any single UOP;
Consists of fuel, lubricants, water, and similar items, reasonably expected to be consumed in 12 months or less, beginning when used in the taxpayer’s operations;
Is a UOP that has an economic useful life of 12 months or less, beginning when the property is used or consumed in the taxpayer’s operations;
Is a UOP that has an acquisition cost or production cost of $200 or less; or
Is identified in published IRS guidance as materials and supplies.
In addition, the new regulations divide materials and supplies into three categories:
Incidental supplies, for which no record of consumption is kept or of which physical inventories at the beginning and end of the taxable year are not taken, are deductible when paid or incurred
Non-incidental supplies are deductible when they are first used or consumed.
Rotable and temporary spare parts are generally deductible upon disposal.
De minimis safe harbor. The regulations allow a taxpayer to deduct certain limited amounts paid for tangible property that are expensed for financial accounting purposes. A taxpayer with an applicable financial statement (which can be a certified audited financial statement used for credit purposes, reporting to partners, or other non-tax purposes) may rely on the de minimis safe harbor if no more than $5,000 per invoice, or per item as substantiated by the invoice, was paid for the property. For businesses without an applicable financial statement (AFS), the maximum figure is $500 rather than $5,000.
To use the safe harbor, the business must have accounting procedures in place at the beginning of the tax year that treat as an expense amounts paid for property that costs less than a specified dollar amount or has an economic useful life of 12 months or less.
Routine maintenance safe harbor. The regulations include a safe harbor that allows certain expenses of routine maintenance to be deducted rather than capitalized. Routine maintenance means recurring activities that keep business property in ordinarily efficient operating condition, such as inspection, cleaning, testing, and replacement of damaged or worn parts.
For a building structure or system, the taxpayer must reasonably expect to perform the maintenance more than once during the 10-year period that begins when the structure or system is placed in service. For property other than buildings, the taxpayer must reasonably expect to perform the activities more than once during the property’s class life for depreciation purposes.
Per-building safe harbor for qualifying small taxpayers. The regulations add a new safe harbor that allows qualifying small taxpayers-those with average annual gross receipts of $10 million or less in the three preceding tax years-to deduct improvements made to a building property with an unadjusted basis of $1 million or less. This safe harbor applies only if the total amount paid during the tax year for repairs, maintenance, and improvements to the building doesn’t exceed the lesser of $10,000 or 2% of the building’s unadjusted basis.
Accounting method changes. Any changes to conform to the regulations are considered changes in accounting methods. Generally, such changes require the filing of Form 3115 (Application for Change in Accounting Method) and calculation of an IRC Section 481(a) adjustment. A Section 481(a) adjustment is the amount required to report income for the year of change as if you had always been on the new method of accounting. Form 3115 must be filed with the IRS Office in Ogden, Utah and a copy must also be attached to your 2014 federal income tax return.
An exception to filing Form 3115 exists for taxpayers with separate and distinct trades or businesses with total assets of less than $10 million or average annual gross receipts of $10 million or less for the prior three taxable years. Qualifying taxpayers are permitted to adopt changes in accounting methods under the new tangible property regulations on a prospective basis for the first taxable year beginning on or after January 1, 2014. These taxpayers forego the opportunity for a late partial disposition of any assets capitalized in prior years and do not receive audit protection for their method of accounting used in prior tax years.
In complying with the new regulations, we advise that most taxpayers should adopt the following accounting method changes which are referred to as DCNs (Designated Change Number) 184, 186 and 192 as follows:
DCN 184 – Change to deducting amounts paid or incurred for repair and maintenance or a change to capitalizing amounts paid or incurred for improvements to tangible property and, if depreciable, to depreciating such property. This includes a change, if any, in the method of identifying the unit of property, or in the case of a building, identifying the building structure or building systems for the purpose of making this change. This also includes a change to deducting amounts paid or incurred for routine maintenance. Additionally, improvements to tangible property are defined to include expenditures that better a unit of property, restore it, or adapt it to a new and different use.
DCN 186 – Change to deducting non-incidental materials and supplies when used or consumed.
DCN 192 – Change to capitalizing acquisition or production costs and, if depreciable, to depreciating such property. This includes a change to capitalizing facilitative costs allocable to real or personal property even if the property is not eventually acquired.
A review of your books and records will be necessary to advise whether or not you should file Form 3115 or elect to adopt the regulations prospectively. With application of the new regulations, other accounting method changes could apply. Click here for a list of additional accounting method changes relevant to the new regulations. Please contact us if you believe any of the additional accounting method changes are applicable to your business.